Insurance is generally considered to be a contract whereby one undertakes to indemnify another against loss, damage or liability from a contingent or unknown event, in exchange for a financial premium. Insurers typically assume most or all of the risk associated with the potential losses, damages, or liabilities with a predefined deductible and a limit of coverage. For example, a directors and officers liability insurer might assume the risk of up to one million dollars (e.g., limit of coverage) of an insured's future potential liability expenses related to their role as either a director or officer of an entity, beyond which the insured assumes any additional risk. Further, the insured might retain a portion of risk by having to pay the first dollars due in a potential claim, which is sometimes referred to as a deductible. For example, a ten-percent deductible on the one million dollar policy would be one hundred thousand dollars, which would typically be paid by the insured before the benefits of the policy can apply.
Two general principles underlying insurance include the concepts of “peril” and “hazard.” A peril may be an actual cause of a loss. Many types of events can result in a peril. A hazard may be anything that increases the chance of a loss or the severity of the loss. Moral hazard is a type of hazard that arises because an entity does not bear the full consequence of its actions, and therefore has a tendency to act less carefully than it otherwise would. As a result, the entity may leave another party to bear some responsibility for the consequences of the entity's actions. In some cases, moral hazard deals with an individual's state of mind, attitudes, behaviors, and habits.